The American Income Tax

Chapter 7

Cost Basis and Exemptions — Riding the Camel

Written by Darrell Anderson.

All animals are equal, but some animals are more equal than others.

George Orwell, Animal Farm

Attempting to legislate this deceptive language was the first appearance of the camel’s nose. Rather than purposely limiting revenue legislation to taxing incomes from explicit sources, such as organized business profits and certain passive gains, the legislators instead tried to reach deep into that bottomless pit to tax anything that conceivably could be labeled income, such as the modest “profits and gains” of the small-scale business person, independent worker, and artisan who normally never maintained books and records. Although the 16th Amendment allowed for taxing incomes “from whatever source derived,” the history of the 16th Amendment indicates that the phrase should not imply or demand that legislators were allowed to embark on fishing trips and wild goose chases to find any circumstantial evidence of “income.” Those early legislators could have solved their problems easily by limiting their revenue collections to explicitly defined activities that generated income in the nature of profits and gains. But they did not. They failed to push the camel’s nose out of the tent.

The result was the 1913 income tax, also known as the Underwood-Simmons Tariff.[1] Despite legislation for an income tax that ran only 15 pages, many people complained of legislators acting in bad faith for enacting a tax that was believed to be reserved for only times of crisis and emergency.[2]

Reading the act and reviewing a 1913 tax return reveals that legislators tried to solve their language and legislative problems with a large exemption of $3,000 per person ($4,000 for married couples and heads of households).[3] Because the typical wage earner and independent worker realized a yearly salary of approximately $500 to $1,000, this exemption was more than sufficient to protect the common wage earner, independent worker, artisan, and small-scale proprietor and to cover the ordinary and necessary expenses of life.

Cordell Hull was the primary author of the 1913 act and at that time was considered by many people as an income tax subject matter expert. He believed that if the Supreme Court justices could justify the 1909 Corporate Excise Tax as a tax on doing business as a corporation that similar logic was possible with respect to “doing business as an individual.”[4] Yet he also believed that although individual humans do not ordinarily maintain a set of books and records like people do with organized businesses, that people nevertheless must be allowed to deduct the ordinary and necessary expenses of life before realizing any gain:[5]

The Treasury regulations soon to be prepared will make clear to every taxpayer the requirements of the law and its application to income derived from the various kinds of business . . . The statutory exemption of $3,000 is allowed for personal living and family expenses . . . . [emphasis added.]

As originally designed, personal deductions were not allowed because the $3,000/$4,000 exemption amount was designed to include those ordinary and necessary expenses. Income was seen as the net increase beyond ordinary and necessary expenses.

In a previous discussion about the then-proposed revenue act, Congressman Palmer of Illinois recognized the need for the exemption:[6]

The second reason that appeals to me is this, that in levying this direct tax upon incomes we ought to rise above the point where the consumption taxes now bear out of all proportion to the incomes, and we ought to leave free and untaxed as a part of the income of every American citizen a sufficient amount to rear and support his family according to the American standard and to educate his children in the best manner which the educational system of the country affords. I think it safe to say that no man with the average American family of five children can support that family according to the proper American standard and send his children through the high schools and colleges of the land who does not have a gross income of $4,000 per annum. Out of that sum must be paid living expenses, interest on debts and other obligations, improvements to the home, education of children through colleges and universities, many comforts and some luxuries which American demand. And if you would not tax education, if you would not retard the development of our people up to the standard at which Americans ought to live, and if you would not doubly tax the poor upon whom these consumption taxes are now levied, you must make this exemption at about the sum of $4,000. [emphasis added.]

Even the Supreme Court justices previously had accepted this idea of a rational exemption to cover the ordinary and necessary expenses of life. In discussing the income tax provisions of the 1894 revenue act, from which the 1913 act was largely mimicked, the justices stated in the Pollock decision:[7]

The basis upon which such exemptions rest is that the general welfare requires that in taxing incomes such exemption should be made as will fairly cover the annual expenses of the average family, and thus prevent the members of such families becoming a charge upon the public. The statute allows corporations, when making returns of their net profits or income, to deduct actual operating and business expenses. Upon like grounds, as I suppose, congress exempted incomes under $4,000.

In his dissenting opinion in Pollock Justice Brown affirmed the concept of the $4,000 exemption:[8]

The exemption of $4,000 is designed, undoubtedly, to cover the actual living expenses of a large majority of families, and the fact that it is not applied to corporations is explained by the fact that corporations have no corresponding expenses. The expenses of earning their profits are, of course, deducted in the same manner as the corresponding expenses of a private individual are deductible from the earnings of his business.

Was this arbitrary exemption amount unfair? That depends upon one’s opinion of the tax. The original intent of the 16th Amendment was to help shift the burdens of taxation from the common worker who shouldered most of the taxation through tariffs and excises to the wealthy who paid little in any proportional amount. The exemption amount certainly targeted the wealthy while protecting the “principle” of the common worker. In those early 1913 discussions Congressman Hull stated:[9]

The exemption of $4,000 was fixed for a number of reasons. In the first place, as already stated, the people with incomes below $4,000 pay the principle part not only of our tariff taxes, but of the State and local taxes, and there is no injustice in requiring those with higher incomes to bear the amount of taxes this bill would impose.

There are those who would say that we should begin at $1,000 in lieu of $4,000. They forget the principle upon which this tax is founded, and that is that every man who is making no more than a living should not be taxed upon living earnings, but should be taxed upon the surplus that he makes over and above that amount necessary for a good living.

Lastly are the words of Senator Borah, one of the principles in the 16th Amendment debates of 1909:[12]

After a man pays the tax which he must pay on consumption, then give him a chance to clothe and educate his family and meet the obligations of citizenship and preparation of those dependent upon him for citizenship before you add any additional tax. That is the basis of this exemption, and it is fair and just to all and toward all.

Let there be no doubt that the legislators in 1913 did not want to tax the typical wages and salaries of the common worker. The first modern income tax was very much a class tax intended to shift the balance of taxation to the wealthy class from the common worker who paid taxes in tariffs and excises. Because income in those days, with respect to taxation, was synonymous with the term net income, in addition for covering the cost of living, the $3,000 exemption purposely exempted the common worker to impose the income tax on the wealthy.

That 1913 act included a $3,000 exemption for single persons ($4,000 for married couples). Consider the effect of that $3,000 exemption that effectively protected the wages and salaries of the common worker. Although many well-to-do people received wages and salaries, in addition to business profits, a significant focus of the tax and 16th Amendment was to reach unearned (investment) income. At a 5 percent annual return, a person would need investments of $60,000 to produce $3,000 in annual unearned income. Because married couples received a $4,000 exemption, that annual sum would need to be $80,000. Considering that the average annual wages and salaries in that era was somewhere from $500 to $1,000, the tax certainly achieved the purpose of taxing the wealthy and protecting the common worker.

In 1913 a single person receiving income of $5,000 for the year would have paid an income tax of $20. The exemption was $3,000 therefore the effective taxable income was $2,000. At a 1 percent levy, the tax was $20. Some people might argue that such people paid virtually no tax at all, but that statement would be false. Such people still paid taxes indirectly, through tariffs, excises, sales taxes, inheritance taxes, and property taxes.

Any person who realized wages or salaries in excess of that statutory exemption amount was deceived into treating that “excess” as income in the nature of profits and gains. Throughout the period and the 16th Amendment debate, wages and salaries were never the subject of any income tax and never were considered income in the nature of profits and gains. Suddenly a portion of wages and salaries were identified exactly as such. This tax on individual humans was a direct tax, but the then-current understanding of the 16th Amendment allowed for such a direct tax. The magic used was to statutorily classify wages and salaries in excess of an arbitrary amount as profits and gains. Through this sleight-of-hand, and because so few people originally were affected, legislators eventually fooled many people into ignoring that wages and salaries — at any level — were not income in the nature of profits and gains. Because of the dual meaning of the word income, thus began the ever-slow confusion about the meaning and nature of income with respect to taxation.

The challenge with this fiat exemption ceiling was that legislators were establishing a subjective statutory cost basis from which income could be realized. Every healthy and sane working person knows that when people work for wages and salaries that there is no gain but only a direct fair market exchange and conversion of assets. The statutory exemption established a fictitious cost basis from which legislators and administrators could “discover” income in the nature of profits and gains. The infamous clause of “from whatever source derived” had triumphed. This deceptive approach has caused nothing but hate and discontent from the beginning of the modern income tax.

The rich were supposed to be the target of this tax, but with the first income tax act the wealthy were already maneuvering the political machinery to avoid taxation. Section II paragraph G lists the various exceptions to the income tax:[13]

Provided, however, That nothing in this section shall apply to . . . to any corporation or association organized and operated exclusively for religious, charitable, scientific, or educational purposes, no part of the net income of which inures to the benefit of any private stockholder or individual, nor to business leagues, nor to chambers of commerce or boards of trade, not organized for profit or no part of the net income of which inures to the benefit of the private stockholder or individual . . . .

Reading subsequent revenue acts reveal that legislators routinely tinkered with their experiment. In 1916, with the Emergency Revenue Act, legislators increased the tax rates.[14] With the War Revenue Act of 1917, because of World War I, legislators again raised the tax rates and reduced the $3,000/$4,000 exemption to $1,000/$2,000.[15] Much like the War Among the States, the income tax quickly became a popular political tool.

In 1919 legislators codified for the first time the existing revenue laws.[16] The codification was not an external collection of statutes, but merely a codification within the statutes that would continue with subsequent bills. They increased the maximum tax rate to an incredible 77 percent (12 percent normal tax and 65 percent surtax on incomes greater than $1 million.[17] They maintained the exemptions at the 1917 level, but added a $200 exemption for each dependent.[18] For the first time legislators formally defined the terms “net income”[19] and “gross income.”[20] Explicitly included for the first time as being subject to the individual income tax were the President of the United States, the judges of the Supreme and inferior courts of the United States, and all other officers and employees, whether elected or appointed, of the United States, Alaska, Hawaii, or any political subdivision thereof, or the District of Columbia.[21] A federal judge in western Kentucky successfully challenged the tax.[22] Tax returns were declared public records and the Commissioner of Internal Revenue was tasked with preparing lists of the names and mailing addresses of people filing returns.[23] Publicly disclosing taxes paid would be allowed with the 1924 Act.[24] Legislators curtailed that idea with the 1926 Act.[25]

During the post-war years legislators began a series of tax cuts. In 1921 legislators raised the dependent exemption to $400,[26] and the married exemption to $2,500.[27] In 1926 legislators raised those amounts to $1,500 and $3,500 respectively,[28] but with the Great Depression in 1932 lowered the numbers to $1,000 and $2,500,[29] where those levels remained until 1940. Legislators never restored the exemptions to the 1913 level of $3,000/$4,000 or any similar proportion.

Lowering the exemption ceiling brought additional Americans into the income tax fold, although not in significant numbers. People can witness this effect by reading the 1920 novel Main Street written by Sinclair Lewis. The book was published only seven years after the first modern income tax act, and plausibly, Lewis was writing this book in 1919 or sooner. One of the main characters in that book, the rural Minnesota medical doctor Will Kennicott, was facing an income tax on his “excess” salary as an independent worker and professional. The conversation in that novel centered around “ordinary and necessary” business deductions and expenses.[30] Kennicott argued that automotive expenses ought to be considered expenses. In other words, such expenses were a cost of his doing business (doctors then made a lot of house calls). Because income was understood as net income (profit and gain), arguing for this cost of doing business necessarily would reduce his net income and hence, any income tax. This debate about what constitutes “ordinary and necessary” expenses, of which many people today are intimately familiar, already existed only a few years after enacting the income tax laws. The confusing and damaging effects of this fiat exemption ceiling and the potential for misinterpreting the meaning of the term income was already in place, decades before any of us today were but a twinkle in our parents’ eyes.

These early income tax acts established two problematic perceptions. First, along with all small-scale proprietors, all independent workers, artisans, and professionals were lumped into the general category known as being engaged in a “trade or business.” Regardless of such a person’s personal or vocational goals, such people eventually were perceived to be required to maintain books and records for being engaged in a trade or business. This attitude has created today the awful burden of every person having to maintain “books and records.”

Second, all wages or salaries in excess of the arbitrary statutory exemption amount, regardless of how received, either through direct employment or independently, was considered income in the nature of profits and gains. This flawed approach gave rise to the eventual misunderstanding that wages (and salaries) are equivalent to business profits and unearned gains. This is a theory that many people reject.

Regardless, all the people who for years have argued that wages are not income were correct. Income was considered business profits and unearned gain. But all the legal scholars who have argued that wages are income were correct too. With respect to how the actual legislation functions, the correct statement should be “all wages and salaries received in excess of the statutory exemption is, for the purposes of taxation, considered income in the nature of profits or gains.” The result could be nothing but confusion, anger, and hotly contested debate.